With life insurance policies protected from creditors in most states, the tax treatment is the next big issue for consumers. Tax treatment as it relates to ownership and beneficiary designations can be a source of confusion. The topic gets tricky because it involves U.S. ordinary income taxes (for the beneficiary) and federal estate taxes (on the estate tax return of the deceased).
- If your estate exceeds your state's estate tax exemption threshold, it may be wise to place your ownership of any life insurance in an irrevocable life insurance trust.
- Proceeds of a death benefit payout will not be included as part of your taxable estate if a trust, not an individual owns the policy.
- For most people without high net worth, naming beneficiaries individually on life insurance policies makes more sense than opening a trust.
- Spouses can pass assets estate-tax-free upon one of their deaths.
- A trust is an entity, not a person, which makes a difference when it comes to life insurance policy payouts.
Trust Ownership of the Policy
If your life insurance beneficiary is your spouse, there's no issue; assets pass estate-tax-free between spouses no matter the amount (as long as the spouse is a U.S. citizen).
However, depending on what state you live in, if your estate is larger than your state's estate tax exemption threshold, you may want to consider putting ownership of your life insurance policy in an irrevocable life insurance trust (ILIT) in anticipation of the taxes due at the death of the surviving spouse. While the federal estate tax exemption is $12.06 million for 2022 and $12.92 million for 2023, a number of states have exemptions that are much lower.
Every state has different estate exemption and rate legislation. For example, Oregon's estate tax exemption is only $1 million, among the lowest in the United States.
Why? By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%. Revocable trusts will not qualify for the exclusion. If the policy is new, name the trust, as opposed to a will, as the owner immediately. If the policy exists, you can transfer ownership to the trust.
Be aware that to eliminate deathbed transfers, the government mandates that you must survive the transfer by three years or your estate will be taxed anyway. Also, if the value of cashing in the policy before you die is more than $16,000 in 2022 or $17,000 in 2023, the transfer may use up part of your gift and estate tax exemptions.
If you name your spouse as the beneficiary of your life insurance policy, there are generally no tax liabilities pertaining to the lump-sum payout.
Life Insurance Beneficiaries
In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as a beneficiary. If your beneficiaries have creditor issues, suffer from mental health problems, can't be trusted with large sums of cash, or have primary beneficiaries who are minors or have drug issues, or if other unique scenarios apply, then naming the trust as beneficiary might be a better route.
For federal tax purposes, if a spouse is named as the beneficiary, then life insurance proceeds received upon the death of the insured are generally income- and estate-tax-free (if paid in a lump sum).
Trusts are not considered individuals; therefore, life insurance proceeds paid to trusts are generally subjected to estate tax. Also, the proceeds payable to a trust may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.
What Are Some Basics of Naming a Beneficiary of a Life Insurance Policy?
Naming your spouse as the beneficiary is the most accessible and most beneficial choice because assets pass estate-tax-free between spouses no matter the amount as long as the spouse is a U.S. citizen. If your estate is larger than your state's estate tax exemption, it might be wise to put the ownership of your life insurance policy in an irrevocable life insurance trust. You would do this to offset taxes that would come due at the death of your surviving spouse.
What Are Some Cautions With Respect to Naming the Beneficiary?
If any of your beneficiaries have mental health or addiction problems, can't be trusted to manage or make wise decisions with a large inheritance, or any other reasons, it might be wise to place the money in a trust, with directions for the trustee on how to distribute the funds to your heirs.
What Is the Disadvantage of Naming a Trust as a Beneficiary of a Life Insurance Policy?
When named as the beneficiary for a life insurance policy, a trust may be bound to unfavorable conditions. For example, retirement plan assets will be subject to required minimum distribution payouts based on the life expectancy of the oldest beneficiary. In addition, there may be unfavorable tax consequences as trusts are not considered individuals and may be subjected to estate taxes.
Can You Change the Beneficiary of an Irrevocable Life Insurance Trust?
True to their name, irrevocable life insurance trusts are irrevocable in nature. This means once they are set up, changes to the trust can not be made. This includes changes to the beneficiaries, even if you experience a divorce or change in preference of who should be beneficiary.
The Bottom Line
Listing beneficiaries for life insurance while having a trust is complicated for legal and taxation reasons. In general, listing a spouse is often not an issue as trust assets in many states usually transfer to the living spouse. It is often more favorable to list specific beneficiaries on the life insurance policy as opposed to the trust. In both situations, be mindful of IRS gift tax exclusions or estate tax exclusions that may have large tax implications.